Tuesday, 18 November 2008

How to Improve Chances of Picking Mutual Fund Winners

Mutual funds are a prime vehicle for many people to save and invest in pursuit of financial goals. However, not just any mutual fund will do as some mutual funds are winners and some are losers. In fact, most mutual funds generate lower returns than market benchmarks, as has been extensively documented for many countries (e.g. for Canada, see the readable book What Kind of Investor Are You? by Richard Deaves, a professor of Finance at McMaster University).

The problem is that doing what sounds sensible and what most investors do - picking past winners, the funds that have performed best up to now - does not work! The disclaimer warning that "past performance may not be repeated" can be restated as "past performance is not likely to be repeated". Performance persistence is weak at best, with a slight majority of funds that outperformed continuing to do so and for only one year (Deaves, p.107). Interestingly, poor performance lasts a bit longer and the effect is a bit stronger, so one lesson is to be more impatient with losers.

The main objective however, is to find the winners. The method is not foolproof but the best selection criteria is to pick the funds with the lowest costs. Costs in the form of management fees, sales charges, administrative charges, trading expenses, legal fees and auditing expenses reduce returns and that affects what you as an investor receive net. The costs are not large as an annual percentage, which is probably why many people don't notice them much, but they do add up over years.

How to Find the Low Cost Funds:
  • Step 1 Go to a mutual fund resource website like GlobeFund, Morningstar Canada or FundLibrary, or use the tool in your broker website. Find the fund filter tool, select the asset class and search and sort by the Management Expense Ratio (MER) from low to high
  • Step 2 Pick out a handful with the lowest MERs. Be wary of any funds where the search result shows 0% MER; that's just not possible and is a data collection error - e.g. in the sample search result below, the BonaVista Global Balanced A Fund actually charges a 1.25% annual management fee. Cross-checking data reduces chances of deciding based on such errors. Focus on those with no Sales charges aka Loads; Front end charges reduce your initial investment while Deferred sales charges penalize you if you withdraw funds within a few years of initial purchase.
  • Step 3 Go to the Mutual Fund company's website and find the latest Management Report on Fund Performance for the fund. Alternatively go to SEDAR.com, the website of the Canadian Securities Administrators where all the companies must file such reports. Within the report do a search for the word "turnover"; nearby should be the Trading Expense Ratio, which tells you how much the fund is spending on buying and selling commissions. (see example of Templeton Canadian Small-Cap Equity Fund below) Trading costs often approach or exceed the MER of a fund and can be a significant drag on performance.
  • Step 4 Add up Trading and Management Expenses. The lower the total expenses the better the future performance of the fund is likely to be.
More Reading:
US Securities and Exchange Commission Look at More Than a Fund's Past Performance
Fundscope's The True Cost of Funds
Common Sense on Mutual Funds by John C. Bogle at Chapters
Mutual Fund Fee Impact Calculator at Ontario Securities Commission Investored.ca website

1 comment:

Dale Rathgeber said...

It is actually posssible to use past performance as a good indicator of future performance provided:(1)you hold your funds for a short time (90 days; and,(2)you consider both very recent, and very long term out-performance. Using this methodology (and autumn abstinence) my group has achieved returns averaging 17% per year since 2002. See octoberstrategy.com

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